Plugging the “pipeline” creates double taxation issue

In a recent blog post I looked at a number of impacts that may be experienced by Canadian business owners should recent tax proposals become law.

Many of these are more germane to long-term tax planning, however, one of them may have very immediate consequences. In the case where a business owner passes away or has recently passed away, the estate and executors will likely face immediate issues—and the potential for double taxation.

When a business owner passes away, he/she is deemed to have disposed of all capital property, including shares of his/her private company, for proceeds equal to their fair market value immediately before death, and any resulting gain will be taxed at the relevant capital gains tax rate. However, when the estate winds up or liquidates the company over time, under the proposed legislation the beneficiaries of the estate will receive dividends and will be subject to tax on the same amount for which the deceased owner paid capital gains taxes; in other words, there is the potential for double taxation.

In the past, “pipeline” planning allowed the estate to transfer the shares of the private company to a new holding company in exchange for a promissory note equal to the value at the time of death, and shares for any value in excess of that amount. Funds would then be distributed by the private company to the new holding company as a tax-free inter-corporate dividend and the promissory note is repaid without further tax.

This mechanism enables the beneficiaries to extract the assets from the private company without additional shareholder tax given that the estate has already paid tax on the gain in the shares on death. However, under the new proposals, the transfer of the private company shares in return for a promissory note would now trigger a dividend, even though the deceased has already paid capital gains tax on death.

If pipeline planning is no longer a viable alternative, there will be essentially only two tax efficient options when private business owners pass away:

Within the first year of the estate, executors can redeem the private company shares and trigger a deemed dividend which reduces the cost of the shares thereby, creating a capital loss which the estate can use to offset the capital gains triggered on death. In other words, this strategy converts the capital gain realized by the deceased into dividends. It’s worth noting, however, that making the decision to do this so quickly may be both impractical and problematic, especially if the will is challenged or other litigation holds up settlement of the estate beyond the allotted year.

Alternatively, the estate can sell the private company shares to an unrelated third party through a holding company—a solution that, in essence, could see a loss in family ownership of a business that has been in the family for generations. This tax policy change can affect the whole family business succession model and may have significant consequences for tomorrow’s private business community.

For those involved in executing the estate of a private business owner who has recently died or who is expected to die imminently, figuring out the best way to manage things is an immediate concern.